Unit Six

6. Incremental Analysis:
Decisions Making and relevant
information
• How many decisions have you made
today?
 Maybe you made a big one, such as
accepting a job offer.
 Maybe your decision was as simple as
settling on your plans for the weekend or
choosing a restaurant for dinner.
• Regardless of whether decisions are
significant or routine, most people follow a
simple, logical process when making them.
• This process involves gathering information,
making predictions, making a choice, acting
on the choice, and evaluating results.
• It also includes deciding what costs and
benefits each choice affords. Some costs are
irrelevant
• For example, once a coffee maker is
purchased, its cost is irrelevant when
deciding how much money a person saves
each time he or she drinks coffee at home
versus buying it at Starbucks. The cost of
the coffee maker was incurred in the past,
and the money is spent and can’t be
recouped
• This chapter will explain which costs and
benefits are relevant and which are not—
and how you should think of them when
choosing among alternatives
• Decision-making is essentially a process of
selecting the best alternative given the
available information for comparison of
strengths and weaknesses of each alternative.
• If there exists no alternative to the current
course of action, then there is no decision to
be made. However, it is rare regarding any
course of action for there not be alternatives
6.1 Information and the Decision Process

 Managers usually follow a decision model

for choosing among different courses of
action.
 A decision model is a formal method of
making a choice that often involves both
quantitative and qualitative analyses.
Management accountants analyze and
present relevant data to guide managers’
decisions.
• Consider a strategic decision facing
management at NIKE manufacturing company
Should it reorganize its manufacturing
operations to reduce manufacturing labor costs?
Suppose NIKE has only two alternatives: Do not
reorganize or reorganize.
• Reorganization will eliminate all manual
handling of materials. Current manufacturing
labor consists of 20 workers—15 workers
operate machines, and 5 workers handle
materials. The 5 materials-handling workers
have been hired on contracts that permit layoffs
without additional payments. Each worker
works 2,000 hours annually. Reorganization is
predicted to cost $90,000 each year (mostly for
new equipment leases).
 Step 1: Should NIKE reorganize its manufacturing
Identify the operations to reduce manufacturing labor costs?
Problem and An important uncertainty is how the
Uncertainties reorganization will affect employee morale

Step 2:
Obtain Historical hourly wage rates are $14 per hour. However, a
Information recently negotiated increase in employee benefits of $2 per
hour will increase wages to $16 per hour. The reorganization of
manufacturing operations is expected to reduce the number
of workers from 20 to 15 by eliminating all 5 workers who
handle materials. The reorganization is likely to have negative
Step 3: effects on employee morale.
Make
Predictions
Managers use information from Step 2 as a basis for predicting
About the Future
future manufacturing labor costs. Under the existing do-not
reorganize alternative, costs are predicted to be $640,000 (20
workers 2,000 hours per worker per year $16 per hour), and
under the reorganize alternative, costs are predicted to be
$480,000 (15 workers 2,000 hours per worker per year $16 per
hour). Recall, the reorganization is predicted to cost $90,000 per
year.
 Managers compare the predicted benefits calculated in
Step 4: Step 3 ($640,000 - $480,000 = $160,000—that is, savings
Make Decisions from eliminating materials-handling labor costs, 5
by Choosing workers 2,000 hours per worker per year $16 per hour
Among = $160,000) against the cost of the reorganization
Alternatives ($90,000) along with other considerations (such as likely
negative effects on employee morale). Management
chooses the reorganize alternative because the financial
benefits are significant and the effects on employee
morale are expected to be temporary and relatively
small

Step 5: Evaluating performance after the decision is

Implement the implemented provides critical feedback for managers,
Decision, Evaluate and the five-step sequence is then repeated in whole or in
Performance, and part. Managers learn from actual results that the new
Learn manufacturing labor costs are $540,000, rather than the
predicted $480,000, because of lower-than-expected
manufacturing labor productivity. This (now) historical
information can help managers make better subsequent
predictions that allow for more learning time.
Alternatively, managers may improve implementation
via employee training and better supervision.
6.2:Incremental analysis: Relevant cost and
Relevant revenue
• Incremental analysis is a decision-making
tool in which the relevant costs and
revenues of one alternative are compared
to the relevant costs and revenues of
another alternative
 Incremental Analysis
• Occurs when there is more than one
alternative choice of action.
Alternative One Alternative Two
 Important Definitions
• Relevant Cost. Costs and revenues that do not
differ between alternatives.
– These can be ignored in incremental analysis
• Opportunity Cost. The benefit given up when one
alternative is chosen over another.
– Opportunity costs are never found in the general
ledger.
• Sunk Cost. A cost that has already been incurred
and will not be changed or avoided by any future
decision.
– Sunk costs are not relevant costs.
 Relevant costs are expected future costs,
and relevant revenues are expected future
revenues that differ among the alternative
courses of action being considered.
• Revenues and costs that are not relevant
are said to be irrelevant.
• It is important to recognize that to be relevant
costs and relevant revenues they must:
 Occur in the future—every decision deals
with selecting a course of action based on its
expected future results.
• Differ among the alternative courses of
action—costs and revenues that do not differ
will not matter and, hence, will have no
bearing on the decision being made.
• The relevant costs—the $640,000 and
$480,000 expected future manufacturing
labor costs and the $90,000 expected
future reorganization costs that differ
between the two alternatives
 Qualitative and Quantitative Relevant
Information
• Managers divide the outcomes of decisions into two broad
categories: quantitative and qualitative.
 Quantitative factors are outcomes that are measured in
numerical terms.
• Some quantitative factors are financial; they can be
expressed in monetary terms.
• Examples include the cost of direct materials, direct
manufacturing labor, and marketing.
• Other quantitative factors are nonfinancial; they can be
measured numerically, but they are not expressed in
monetary terms. Reduction in new product-development
time.
• Qualitative factors are outcomes that are
difficult to measure accurately in numerical
terms. Employee morale is an example.
• Relevant-cost analysis generally emphasizes
quantitative factors that can be expressed in
financial terms.
• But just because qualitative factors and
quantitative nonfinancial factors cannot be
measured easily in financial terms does not
make them unimportant
• In fact, managers must wisely weight these
factors. In the NIKE Products example,
managers carefully considered the negative
effect on employee morale of laying-off
materials handling workers, a qualitative
factor, before choosing the reorganize
alternative.
• Comparing and trading off nonfinancial
and financial considerations is seldom easy.
 Types of Incremental Analysis

Under appropriate circumstances, incremental

analysis is a tool for evaluating decision
alternatives such as:

Accept an order at a special price

Make or buy components or finished products

Sell products or process further

Retain or replace equipment

Eliminate an unprofitable business segment

LO 2: Describe the concept of incremental analysis.

An illustrations for relevance : case 1 : one time only special
order

• One type of decision that affects output levels is accepting or rejecting

special orders when there is idle production capacity and the special
orders have no long-run implications. We use the term one-time-only
special order to describe these conditions.
• Example 1: ALMEDA manufactures quality beach towels at Addis
Ababa. The plant has a production capacity of 48,000 towels each
month. Current monthly production is 30,000 towels. Retail
department stores account for all existing sales. As a result of a strike
at its existing towel supplier, Jupiter , a luxury hotel chain, has offered
to buy 5,000 towels from Almeda in August at $11 per towel. No
subsequent sales to Jupitor are anticipated. Fixed manufacturing costs
are based on the 48,000-towel production capacity. Should ALMEDA
accept offer of to produce the towels Jupitor hotel only ?
• Additional information :
 Example continues
• The variable manufacturing cost per unit
is $7.50
• Selling price per unit is $ 20
• The fixed manufacturing cost is $ 4.50
 Total Per unit
Unit sold 30,000

Revenue 600,000 $20

Less :Cost of good sold
variable Manufacturing cost (225,000) 7.50
Fixed manufacturing cost (135,000) 4.50
Total cost of good sold 360,000 $12
Less : Marketing cost
variable marketing cost (150,000) 5
Fixed marketing cost (60,000) 2
Total marketing cost 210,000 $7
Full cost of the production 570,000 $19
Operating income 30,000 $1
• The manufacturing cost per unit of $12—
which is greater than the $11-per-unit
price offered by Jupiter — So, the manager
might decide to reject the offer.
• Case 2: assume the offer of 5,000 towels
comes with cost of $ 11 apart from
productions of 30,000 unit under a
normal circumstance( selling price of $20
of 30,000units ).
1. Does the company accept the offer or
not ?
2. Tell me the relevant cost and relevant
revenue ?
 Without special order With special order Difference :
30,000 35,000 relevant
amount
Unit to be sold Unit to be sold 5000 u
Per unit Total
(1) (2)=1 *30,000 (3) 4=(3)-(2)
Revenue $20 $600,000 $655,000 55,000
Variable cost
Manufacturing cost 7.5 225,000 262,500 37,500
Marketing cost 5.0 150,000 150,000 0
Total variable cost 12.50 $375,000 $412,500 37,500
Contribution margin 7.50 225,000 242,000 17,500
Fixed cost :
Manufacturing 4.50 135,000 135,000 0
marketing 2 $60,000 $60,000 0
Total fixed cost 6.5 $ 195,000 $ 195,000 0
Operating income 1 $30,000 $47,500 17,500
2. the relevant cost is variable
manufacturing cost $7.50 x 5,000u=37,500
 The relevant revenue is 55,000
($11x5,000u).
 So, you will get additional revenues of
$17,500
 Relevance cost :Insourcing-versus-Outsourcing and
Make-versus-Buy Decisions

A. Outsourcing
• Outsourcing is purchasing goods and services
from outside vendors rather than producing the
same goods or providing the same services within
the organization, which is insourcing.
• For example, Kodak prefers to manufacture its
own film (insourcing) but has IBM do its data
processing (outsourcing). Honda relies on outside
vendors to supply some component parts but
chooses to manufacture other parts internally
• Decisions about whether a producer of goods
or services will insource or outsource are also
called make-or-buy decisions.
 Surveys of companies indicate that managers
consider :
 Quality,
 Dependability of suppliers, and
 Costs as the most important factors in the
make-or-buy decision.
 Sometimes, however, qualitative factors
dominate management’s make-or-buy decision.
• For example, Dell Computer buys the chip
for its personal computers from Intel
because Dell does not have the know-how
and technology to make the chip itself.
• In contrast, to maintain the secrecy of its
formula, Coca-Cola does not outsource the
manufacture of its concentrate.
• Example
Example: Costs to produce 6,000units

per unit Total

DM $10 60,000
DL 8 48,000
Applied Variable 9 54,000
factory overhead
Applied fixed 12 72,000
overhead
$39 $234,000
 Buying the switches eliminates all
variable costs, but only $9 of fixed
costs
However, $3 of fixed costs remain
even if the switches are purchased
 Solution
Per unit Total
Make Buy make Buy
Purchase $29 $174,000
price
DM $10 $60,000
DL 8 48,000
Variable over 9 54,000
head
Relevant fixed 3 18,000
overhead
Total relevant $30 $29 $180,000 $174,000
cost
1 $6,000
Management must decide whether to
make or buy components.
The decision to buy parts or services
rather than making them is called
outsourcing.
Example: Costs to produce 25,000
switches
Continues
Switches can be purchased for $8 per
switch (25,000 x $8 = $200,000)
At first look, the switches should be
purchased; thus saving $1 per unit
Buying the switches eliminates all variable
costs, but only $10,000 of fixed costs
However, $50,000 of fixed costs remain
even if the switches are purchased
The relevant costs for incremental
analysis are:

Baron Company will incur $25,000 additional cost if switches

are purchased
Continue to make switches
• In a make-or-buy decision, relevant
costs are:
a. Manufacturing costs that will be saved.
b. The purchase price of the units.
c. Opportunity costs.
d. All of the above.
 Sell or Process Further

Many manufacturers have the option of selling a

product now or continuing to process the product
hoping to sell the refined product at a higher price

Decision Rule:
Process further as long as
the incremental revenue from
such processing exceeds the
incremental processing costs

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further - Example

Single-Product Case
Cost to manufacture one unfinished table:

Selling price of unfinished unit is $50; unused capacity

can be used to finish the tables to sell for $60
Relevant unit costs of finishing tables:
Direct materials increase $2; Direct labor increases $4
Variable manufacturing overhead costs increase by $2.40
Fixed manufacturing costs will not increase

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further

Incremental revenues ($10) exceed incremental costs

($8.40); Income increases $1.60 per unit
Process further

LO 5: Identify the relevant costs in determining whether

to sell or process materials further .
 Sell or Process Further
Multiple-Product Case

In many industries, a number of end-products are

produced from a single raw material and a common
production process
Multiple end-products are commonly called joint
products
Petroleum – gasoline, lubricating oil, kerosene
Meat Packing – meat, hides, bones

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further

Multiple-Product Case
All costs incurred prior to the point at which the products are
separately identifiable (the split-off point) are called joint costs

Joint costs are (for purposes of determining product cost)

allocated to individual products on the basis of relative sales
value

Joint costs are not relevant for any sell-or-process-further

decisions

Joint product costs are sunk costs.

They have already been incurred and cannot be changed

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further - Example

Multiple-Product Case

Marais Creamery must decide whether to:

Sell cream and skim milk now
or
Process each further before selling

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further – Example Continued

The daily cost and revenue data for Marais Creamery are:

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further – Example Continued

Sell cream or process further into cottage cheese?

Do not process cream further:

To do so will incur an incremental loss of $2,000

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Sell or Process Further

Sell skim milk or process further into condensed milk?

Marais should process the skim milk:

To do so will increase net income by $7,000

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Let’s Review
The decision rule in a sell-or-process-further decision
is:
process further as long as the incremental revenue
from processing exceeds:

a. Incremental processing costs.

b. Variable processing costs.
c. Fixed processing costs.
d. No correct answer is given.

LO 5: Identify the relevant costs in determining whether

to sell or process materials further.
 Retain or Replace Equipment
Management must decide whether a company should
continue to use an asset or replace it
Example: Assessment of replacement of a factory
machine:
Old Machine New Machine
Book value $40,000
Cost $120,000
Remaining useful life four years four years
Scrap value -0- -0-

Variable costs:
$160,000
& $125,000 annually respectively

LO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.
 Retain
Retainor
orReplace
ReplaceEquipment
Equipment--Example
Example

Replace the equipment - Lower variable manufacturing costs

more than offset cost of new equipment.
The book value of the old machine does not affect the decision
– it is a sunk cost.
However, any trade-in allowance or cash disposal value of the
old asset is relevant

LO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.
 Let’s Review
In a decision to retain or replace equipment, the book
value of the old equipment is a(an):

a. Opportunity cost.
b. Sunk cost.
c. Incremental cost.
d. Marginal cost.

LO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.
 Eliminate an Unprofitable Segment

Should the company eliminate an unprofitable

segment?
Key: Focus on relevant costs
Consider effect on related product lines
Fixed costs allocated to the unprofitable segment
must be absorbed by the other segments
Net income may decrease when an unprofitable
segment is eliminated
Decision Rule:
Retain the segment unless fixed costs eliminated
exceed the contribution margin lost

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.
 Eliminate an Unprofitable Segment - Example

Martina Company manufactures three models of tennis

racquets: Profitable lines: Pro and Master
Unprofitable line: Champ

Condensed Income Statement data:

Should the Champ line be eliminated?

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.
 Eliminate an Unprofitable Segment - Example

Assume if Champ is eliminated, must allocate its

$30,000 share of fixed costs: 2/3 to Pro and 1/3 to
Master
Revised Income Statement data:

Total income has decreased by $10,000 ($220,000 -

$210,000)
LO 7: Identify the relevant costs in deciding whether
to eliminate an unprofitable segment.
 Eliminate an Unprofitable Segment - Example
Incremental analysis of Champ provides the same
results:

Decision: Do not eliminate Champ

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.
 Let’s
Let’s Review
Review

If an unprofitable segment is eliminated:

a. Net income will always increase.

b. Variable expenses of the eliminated segment will have to
be absorbed by other segments.
c. Fixed expenses allocated to the eliminated segment will
have to be absorbed by other segments.
d. Net income will always decrease.

LO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment .
• End of chapter six